Monday, September 30, 2013

Could Bitcoin kill Fed monetary policy?

While bitcoin could one day kill most of the roles that the Fed plays, monetary policy will probably stay intact. The reason for this, as I'll show, is that the no matter what happens to all its other functions, the Fed will probably continue to define the economy's unit of account.

Let's start in the present day US. Most modern transactions involve transfers of dollar banknotes, reserves, or dollar-denominated bank deposits. A small minority of transactions are made with bitcoin. But these transactions are rarely priced in terms of bitcoin. Rather, a merchant's website will typically display prices in terms of dollars, and then compute the amount of bitcoin that a customer must fork over by referring to the current dollar-to-bitcoin exchange rate. The dollar is very much the the unit of account in the US, not bitcoin.

The first of the Fed's functions to be killed off by bitcoin will inevitably be the issuance of paper banknotes. Bitcoin enjoys all the benefits of cash, on top of which it can be transferred instantaneously over long distances. Bulky hand-to-hand paper simply can't compete. Unwanted notes will reflux back to banks and then to the Fed. From there Fed officials will cancel and destroy them, the Fed's balance sheet shrinking to a fraction of its previous level. Paper dollars will now be extinct, and the Fed much smaller.

Even with its printing presses idled by bitcoin mania, the Fed will still continue to issue reserves. Reserves are used by banks in the interbank market to settle cheques and make large value payments, normal people don't get to own them.

The Fed has traditionally not paid a pecuniary rate of return on reserves. In other words, it hasn't offered interest. Banks have been willing to hold barren reserves because in addition to their usefulness as payments media, the Fed has exercised its monopoly powers to keep their supply artificially scarce. This combination of usefulness and scarcity conspire to produce significant non-pecuniary benefits that bankers will eagerly pay to enjoy. After all, any banker that holds a base level of scarce reserves can rest easy knowing that they are well-prepared for an uncertain future—a banker that forgos them must bear the discomfort of being ill-equipped to deal with unforeseen events.

The Fed can alter the relative scarcity of reserves via open market operations. This in turn either increases or decreases the non-pecuniary return on reserves, or their marginal usefulness. If increased, the rush to buy reserves causes economy-wide fall in the price level. If decreased, a rise ensues. Thus even though bitcoin has rendered cash extinct, the Fed's power over the economy isn't diminished one iota since prices continue to be priced in the dollar unit of account, and the Fed's artificially scarce reserves are effectively the medium that defines the unit.

But say that bitcoin and a raft of other alt-coins become popular among banks as a way to settle payments among each other. Say these new electronic media are blazingly fast, safer, and far cheaper than the Fed interbank alternative. Banks, their electronic vaults full of bitcoin, no longer want to hold reserves and are lobbying the Fed governor to buy them back with the assets the Fed holds in its vaults. Should this happen, the Fed's balance sheet is set to contract to zero—into irrelevance.

At this point the Fed will have effectively lost its tight grip on the market for interbank settlement media. Reserves will neither be special nor scarce—banks can now hold a wide variety of assets as interbank media. The Fed finds itself powerless. Its traditional tool for manipulating the price level has always been to lever its monopoly power so as to fiddle with the relative scarcity—or specialness—of highly-liquid reserves. But this tool is gone. It can't do anything to control the price level. As for the media it once issued, both cash and reserves have lost their distinct characteristic as "money". They are no longer the most liquid assets in the economy, having been displaced by cryptocoin.

However, this ignores the fact that even though reserves have lost all their monetary usefulness in the face of cryptocoin competition, the Fed still has one other tool at its disposal—it can start to pay a pecuniary return, or interest, on reserves. By raising or lowering the interest rate it offers, it can either entice or repel banks to hold more or less reserves at any given price level. Since the economy's prices continue to be expressed in terms of the dollar, the Fed can now manipulate the economy-wide price-level by jacking up or reducing interest on reserves. Even if there are only a piddling $20 million worth of illiquid reserves outstanding, the Fed can still get a bite on the macroeconomy by changing rates.

So to sum up, though cash has gone the way of the dodo bird, and the Fed has lost its clearinghouse monopoly, and bitcoin is gushing everywhere, the Fed can still exert itself over the economy because it issues the one special asset that defines the unit of account—reserves.
Monetary policy can still exist in a world without central bank money.

The Fed would only become truly powerless when economic actors choose to price their goods in terms of cryptocoin. At that point, Fed reserves will have lost all their traditional uniqueness—they will be just one fixed-income asset among a sea of many millions of fixed-income assets. The economy's unit of account will be BTC, and the economy-wide price level will now be driven by the vicissitudes of the demand and supply of bitcoin. But a switch in the unit is unlikely since the network effects generated by centuries of tradition are in the dollar's favor. For the time being, bitcoin is just too volatile to be used for price expression.

The Fed needn't worry about becoming irrelevant. Hell, it might even learn a bit from the competition along the way.

Along these lines, give Michael Woodford's Monetary Policy in a World Without Money a read. Written in 2000, Woodford tries to answer whether the "development of 'electronic money' poses any threat to the ability of central bankers to control the value of their national currencies through conventional monetary policy." Nine years before bitcoin even arrived on the scene, academic scribblers like Woodford were already mulling over its potential effect on Fed policy. How's that for forward guidance?

30 comments:

Wouldn't the Fed need to pay interest on its reserves in the form of Bitcoin? Because otherwise it would be trying to persuade people (not just banks) to hold useless bits of paper by offering to pay them more useless bits of paper if they did so. And I don't think that's what Woodford had in mind.

Nick, looking through the paper again, I think you're right. Woodford doesn't really try to grapple with the fact that the technology that displaces Fed reserves could be an entirely new medium. Given that the Fed would need to pay interest in bitcoin, how do you think affects Woodford's story?

I'm not 100% sure yet, but I think it totally destroys Woodford's story. Because Fed reserves would now be equivalent to bonds (or bills?) that promised to pay Bitcoin, so the Fed would have to vary the Bitcoin rate of interest on those bonds to control the price level. It would take some thinking to figure out what the Fed's reaction function would need to be, but I sort of doubt it would look much like a standard Taylor Rule. It's more like an Irving Fisher Compensated Dollar world, with Bitcoin replacing gold.

Nick: I'm not sure, but wouldn't the Fed just be varying the regular interest rate on reserves? Say it reduces the rate from 5% to 4%. $1000 worth of reserves now yields $40, not $50. Reserve-holders are willing to hold less reserves at this price and will simultaneously sell, pushing up the $ prices of all other goods and assets until equilibrium is once again restored.

It's difficult to imagine the quantity of (non-interest-bearing) central bank money falling to zero while the dollar is still the unit of account. But if that did happen somehow, then the central bank would still be able to set interest rates by setting the interest on reserves. It doesn't matter whether Open Market Operations are effective or not.

JP: Do you still think bitcoin is doomed? I mean, given the choice between a regular currency that is backed by assets, and a crypto currency backed by nothing, I'd pick the regular currency. I might make an exception if I thought bitcoin might rise still higher, but other than that I'd go with backed money every time.

Mike, I still think it's doomed. But reality has proven me wrong to date so at some point I'll have to wave the white flag and change my theories. Like you, given the choice I'd go with backed money all the time. However, if I were to get a strong feeling that bitcoin was about to rise to $500, I'd change a big chunk of my $ into bitcoin. Is it speculative fever that is anchoring bitcoin's price? Is it the demand for bitcoin as collector's item, like stamps?

the question of "backing" only makes sense when talking about debt, because it then plays a role in the market price. Bitcoin is not debt, it's a pseudo-commodity. Furthermore, there's the question of transaction costs when choosing a medium of exchnage. Maybe you can read my master's thesis, it's not perfect but it gets the job done.

Agreed. For example, gold originally had value because it was useful, pretty, etc. Once it had value it became used as money, and the more people held it as money, the more its value rose. I'd conjecture that bitcoin originally had some curiosity value, and as people started to use it as money, its value rose.

The nature of common paper/token moneys is different. They are the liability of their issuer, backed by the issuer's assets. They can be costlessly and instantly issued and retired in unlimited amounts. So just like a regular commodity with a horizontal supply curve, the demand for money can change all over the place without affecting its value.

with respect to the origin of the price of Bitcoin, I think I'm actually the one who did the most extensive research in this area. Check out my blog post from two weeks ago: http://www.economicsofbitcoin.com/2013/09/professor-walter-block-is-clueless.html . It's quite close to your conjecture.

I agree that debt can be issued/retired practically costlessly. But it cannot be transferred costlessly, due to regulation, property rights enforcement, principal agent problems and so on.

I am not sure that the demand for money can change without affecting its value, but it's a complicated issue and that's not what I wanted to point out.

I haven't read your post, but I'm familiar with Woodford's article and I referenced it occasionally. There were also a couple of others, like one by Tatsuo Tanaka, but I found Woodford's the most thorough investigation of the monetary policy implications.

Also, since you still think that Bitcoin will fail, what do you think will replace it? I find it odd that you're the one skeptical because you're one of the few economists that actually comprehends the heterogeneity of moneyness (in fact you understand it better than me).

My working hypothesis has been bitcoin failure, but the longer bitcoin sticks around the more likely it is I'll have to drop my hypothesis.

I originally found it unlikely that something without intrinsic value, or non-monetary value, could earn a sustained positive price. If I change my hypothesis it'll be for one of two reasons. 1. I was wrong, and bitcoin does have some non-monetary value that I failed to recognize at the outset. 2. It isn't necessary for media of exchange to have a core of non-monetary value.

Well, purely logically the non-monetary value is not necessary once it works as a medium of exchange already (i.e. it becomes an empirical issue). Mises and Rothbard have made similar arguments. At a sufficient liquidity level the issue becomes irrelevant. What is the sufficient liquidity? I don't know, that's an empirical issue.

If you forget about moneyness and switch to a more generic concept of the network effect and critical mass, maybe it becomes more obvious. Take the internet. It's just numbers and standards (just like Bitcoin), yet it would be odd to argue that it will fail because it has no value outside of the network. In particular IP addresses are just numbers between 0 and 2^32 (approx 4 billion). They are not even secure or secret numbers. The legal system does not recognise property rights in them. Yet, they do have a market price. Conservative estimates from 2011 put a market price at about 20$ per IP and potential market cap at 6-8 billion $. And once you pose the question: what would the internet be replaced with if it fails, you need to address the reason why people use the internet as opposed to other methods of communication.

Now back to moneyness, Bitcoin is not just a medium of exchange, but a financial system as well. Just like from the point of view of human action, the internet is not just numbers and standards, but also communication infrastructure. That is why concentrating on "non-monetary uses" with respect to Bitcoin is an obsolete concept.

I think that the network effect on the unit of account is the last hurdle and the most difficult to overcome, and probably won't happen unless the old UoA (such as the dollar) hyperinflates or hypervolatilises, and even then it's not certain. Rothbard also argued in this sense in "The Case for a Genuine Gold Dollar". The UoA status is also indirectly "subsidised" through laws that have to do with taxes and accounting.

To what extent the UoA affects the possibility to execute monetary policy, I admit that this is a new question for me and I don't have a full answer to that.

On the other hand, I don't think that the high hurdle of becoming a UoA is an obstacle to prevent Bitcoin from spreading as a medium of exchange, and store of value. I think that many Austrians that have so far critiqued Bitcoin do not realise this.

Just last week I was at a Bitcoin convention in Amsterdam and I spoke to several people who have ideas (at least two different ones) about how to reflect the exchange rate of fiat into a cryptocurrency without counterparty risk (i.e. in a decentralised fashion). I had not thought before that this is possible. I must admit I do not understand those approaches thoroughly yet, but if it works it will make it much easier to treat Bitcoin (or a cryptocurrency) as a medium of exchange even if the banks and regulators make problems with converting between fiat and crypto. The user then won't have to engage in forex or hedging or worry about depending on banks in order to compensate for the exchange rate risk.

This post focuses on the ability of bitcoin (and other cryptocurrencies) to compete with the Federal Reserve on transaction costs for transfers between banks, while largely ignoring why banks hold reserves in the first place and the advantages of a central bank in this particular domain. Banks hold reserves for both legal and economic reasons. First, banks are legally required to meet a minimum reserve requirement, held at either the Federal Reserve or a member institution. In theory, these legal barriers to bitcoin reserves could be removed (though it is unclear to me why the Fed or the US government would agree to this). However, even if banks successfully lobbied to hold their reserves wherever they pleased in whatever currency they pleased, they would still need to hold some reserve capital for economic reasons. Absent any reserve capital, small fluctuations in the market would cause the bank to collapse. Banks thus have to hold some capital in reserve if they want to survive a downturn. You note that the Federal Reserve could attract reserve capital back by paying interest, but ignore that the Federal Reserve is uniquely positioned to offer interest on reserves. While a bank could hold its own reserves in bitcoin, it cannot earn interest on those bitcoins or lend those bitcoins to others. In contrast, because of the stability given to the Federal Reserve by its government backing, the fed can and does loan reserves back out, making economic use of the final fraction. This difference is obviously a matter of degree. A bank does not have to literally vault their private reserve, they could put it in a super low-risk, high liquidity private asset, but any such asset would presumably be riskier than a deposit at the fed.The second, related, reason why I doubt that a bitcoin like cryptocurrency could ever be held as a reserve is its instability. The primary value of a crypocurrency is transactional, but its price over time is driven by speculation. At some point, when another currency has greater transactional value, long term bitcoin investors will exit and the value of a bitcoin will crash. While the replacement currency could be created by a private entity, to nicely illustrate this point, imagine that tomorrow the US government announced plans to copy bitcoin’s source code and create dollar-coin, an open source cryptocurrency with all the properties of bitcoin, but a currency that the Federal Reserve agrees to convert into US dollars on a one for one basis. Bitcoin would collapse overnight. Finally, by way of contrast, the transactional value of the dollar cannot be so easily undermined. The US government can credibly commit to not just honor US dollars as legal tender in all transactions, but to require that US taxes be paid in US dollars. In this sense, the government guarantees the long term value of its currency , and thus its transactional value both short and long term, in a way that the makers of private cryptocurrencies cannot.

On your point about required reserves, I'm taking a short cut here and assuming these have been removed. I live in Canada where we've been without the reserve requirement for over a decade.

As for bank reserves, banks would not hold bitcon per se. They would hold dollar-denominated securities that promise to pay out bitcoin. For instance, a $1000 bond with a 10% coupon would pay $100 a year. However, the payment would be in bitcoin at the going bitcoin exchange rate. This means that bonds would provide an indexed return. So bitcoin reserves, held in the form of securities paying out bitcoin, would be steadier than you think.

On the instability of bitcoin, we're probably in agreement. I've written about that many times including here.

While we disagree on the size of the political barriers to eliminating reserve requirements, my main point is not about the politics but the economics of reserves. You write:

"They would hold dollar-denominated securities that promise to pay out bitcoin. For instance, a $1000 bond with a 10% coupon would pay $100 a year. However, the payment would be in bitcoin at the going bitcoin exchange rate. This means that bonds would provide an indexed return. So bitcoin reserves, held in the form of securities paying out bitcoin, would be steadier than you think."

What you have described, were it extremely low risk, would be an amazing investment that would outperform the much higher risk stock market. A guaranteed 10% annual return! Of course, no such investment exists. I realize that you were simply illustrating that the asset would pay be pegged to the dollar and that 10% is a nice round number, but your example in no way resembles a reserve and nicely highlights why we should be skeptical that bitcoin could serve as a reserve currency. First consider the nature of reserves. While assets held outside of a central bank can serve as reserves, the "reserveyness" of an asset depends on its (1) liquidity and (2) its risk of default. Given that this is matter of degree, reserve capital could in theory earn some interest, but to earn interest it has to be loaned out and thus incurs greater risk. The greater the risk the less the asset can be considered a reserve, which traditionally is an asset with near 0 probability of default because it is literally or figuratively cash stashed in a vault. My point is that banks need some amount of reserves to weather downturns that are roughly equivalent to cash stashed in a vault, but that if anyone can loan out this reserve with minimal risk the Fed more than any other counterparty has the ability to loan out this final fraction.

Finally, note that in your example the bitcoin is not the reserve currency but the medium of transaction! Because the asset is dollar denominated the reserve currency remains the dollar because even if the transaction occurs in bitcoins the asset’s value is determined by the value of the dollar.

Interesting, JP. Let me see if I understand the implications. Let's construct 2 imaginary bitcoin Canadian payment systems, one public-private and the other purely private. Could you clarify what is required for monetary policy to still work?

I don't know about details like tranche 1 and 2, but a payments system in a bitcoin universe would be entirely priced in dollars. The amounts transferred would be the bitcoin equivalent at the then bitcoin-to-dollar exchange rate. Monetary policy still works because everything is priced in terms of dollars, not bitcoin.

As we traverse across the spectrum of all assets, is there, empirically, an increasing relationship between moneyness and velocity of circulation (the reciprocal of average holding period)?

My guess is that there would be, but I can imagine exceptions. (For example, if we couldn't rent houses, for moral hazard reasons, but needed to move from city to city a lot, we would hold houses for a short period despite their being illiquid.)

Related: do those assets at the extreme end of the moneyness scale (i.e. "money") always have a higher velocity of circulation than any other asset?

But it's tough to measure an asset's moneyness. To do so we need to price how much people expect to be compensated if they forgo holding an asset for some period of time. We could for instance measure this for Microsoft shares by having people deposit Microsoft shares for a year. They'd still get the dividend, capital appreciation, and voting rights, but the lose out on saleability over that period. The compensation they expect would be a good measure of MSFT's 1-year moneyness.

However, these sorts of markets don't really exist, so it's hard to get a genuine measure of moneyness. But I suspect your hypothesis is a good one and would probably be borne out by the data.

I'm not sure what the total amount is when you include state and local taxes, but its in the trillions every year. So that's trillions worth of dollars that the banks have to use each year to make tax payments (because banks process everyone's tax payments, acting as intermediaries between the government and the rest of the population).

I find it odd that you completely ignore the role of taxes. Mike Sproul has been very clear that "taxes receivable" is one of the assets "backing" state money.

Plus there is the issue of legal tender laws. Don't these state that creditors, including banks, have to accept dollars in payment of debts? This would imply that even if banks started lending bitcoin, everyone, including other banks, would be perfectly entitled to repay them with dollars.